Recently in MF Global Category

"swaying power such as has
never in the world's history been trusted in the hands of mere private citizens,...after having created a system of
quiet but irresistible corruption-will ultimately
succeed in directing government
itself. Under the American form of
society, there is now no authority
capable of effective resistance."

Henry Adams writing about the corruption of the Erie Railroad for
the Westminster
Review in 1870, he described corporate influence growing to the point of being uncheckable with political
parties that would sacrifice principle for accommodation.

Last week, the Head of the
Department of Justice's Criminal Division, Lanny Breuer, announced his
resignation. His resignation is
remarkable only in so far that it draws attention to the enormity of what he
would not do. Under Breuer's
watch, leaving aside some high profile and related insider trading
prosecutions, not one senior Wall Street executive was prosecuted or even
charged (by some accounts- not even investigated) with anything having to do with the worst financial
crisis in American history-a crisis that resulted in a bailout of Wall Street banks and the financial sector
at a cost to American taxpayers of between $43.32-$59.75 billion.[1] A day before Lanny Breuer's resignation, PBS' Frontline aired an investigation
about the failure of the Justice Department to prosecute a single senior banker
involved in the mortgage crisis called, "The Untouchables." During this same time that the
Department of Justice refused to go after a single head of a Wall Street firm,
they took a particularly hard line on a torture whistleblower (not the
torturers), and many financial criminals responsible for not the billions
caused by elite Wall Street firms but between thousands to hundreds of
thousands like elderly couples for possible pension fraud, an appraiser in
Florida, individuals who committed bank fraud by lying on mortgage applications
and other criminals like pot smokers and Aaron Swartz. It is not that I condone wrong-doing,
only a record of selective prosecution on steroids. Lanny Breuer's Justice Department exposed its full fury to
the chubs of the criminal justice systems while systematically saving the
titans and whales.

One
of the reasons, Lanny Breuer gave for the non-prosecution of a senior Wall
Street executive is sympathy for employees and shareholders.In his interview with Martin Smith of
Frontline, Mr. Breuer repeated a specific if selective, empathy, wholly at odds with the
charge he had been given by Senator Kaufman to investigate and hold to account
all those responsible for the financial crisis.[2] This selective empathy is also wholly at odds with the unbiased
way in which most of us naively think justice is administered and prosecutions
are sought.By the way, after this
interview aired, Martin Smith states that he was called by the Justice
Department and told that they would never cooperate with PBS again.[3]

In
September of last year, Mr. Breuer admitted his particular empathy towards the
plight of the largest of Wall Street banks when he addressed the New York Bar
Association and said,

In my conference room, over the years, I have heard sober
predictions that a company or bank
might fail if we indict, that innocent employees could lose their jobs, that
entire industries may be affected, and even that
global markets will feel the effects. Sometimes - though, let me stress, not always - these presentations are compelling.
In reaching every charging decision, we
must take into account the effect of an indictment on innocent employees and shareholders, just as we must
take into account the nature of the crimes committed
and the pervasiveness of the misconduct. I personally feel that it's my
duty to consider whether individual employees with no
responsibility for, or knowledge of, misconduct
committed by others in the same company are going to lose their livelihood if we indict the corporation. In large
multi-national companies, the jobs of tens of thousands of employees can be at stake.
And, in some cases, the health of an industry or the markets are a real factor. Those are the kinds of
considerations in white collar crime cases
that literally keep me up at night, and which must play a role in responsible enforcement.

When the only tool we had to use in cases of corporate misconduct
was a criminal indictment, prosecutors
sometimes had to use a sledgehammer to crack a nut.[4]

It
is odd that this same Justice Department did not take sympathy into account in
demanding that Aaron Swartz serve 35 years or for that matter, the plight of
all smaller defendants.The
omnibus catchall Computer Fraud and Abuse Act ("CFAA") could make criminals of
many of us because it seeks to criminalize the use of a computer without
authorization but no where defines what "authorization" means.

When
the government freezes a defendant's assets or seizes property even before a
filing of charges making it impossible for them to pay for a decent lawyer
(assuming they can even afford one), does it really care how the defendant
(before being proven guilty) manages to eat or live in the interim of years it
can take from investigation to sentencing?

Where
was the sympathy for Senator Ted Stevens?Was it anything but a sheer lack of empathy that led to the
career-ending prosecution of a six term Senator and the deliberate withholding of
exculpatory evidence in his case?What about the many cases where defendants are exonerated by physical
evidence that the prosecution possessed but did not reveal at the time?Where is the sympathy for the years or
decades of a life that are lost because exculpatory evidence is not released or
DNA evidence kits are not processed?Or is the empathy that Lanny Breuer refers to, as selectively held as
its application under Lanny Breuer's tenor suggests?

Conflicts of Money

Money
influences prosecutions.Consider
the tale of two men performing the identical act in the criminal law Jon Corzine
and Russell Wasenfdorf, Sr. Corzine was one of President Obama's elite bundlers in 2011
and 2012.He campaigned heavily
for the President as governor of New Jersey, and held private fundraisers for
President Obama in his home even after MF Global went bankrupt and $1.6 billion
of customer funds went missing in October 2011.The Justice Department announced that they would not
prosecute him.

It
was discovered in June 2012 that Peregrine Financial Group CEO, Russell
Wasendorf Sr., like Corzine at MF Global, had tapped into customer segregated
funds to the tune of $215 million.Russell Wasendorf Sr was arrested and criminally charged later same that
month.Same act-missing
customer funds that were by law not to touched-but a far disparate prosecution.[5]

Under
Lanny Breuer, the Justice Department announced it would not go after Goldman
Sachs. Goldman Sachs' employees were the second largest single contributor to
President Obama in 2008 contributing $1,013,091.[6]
Goldman Sachs is also one of the largest clients of Mr. Eric Holder's lawyer
firm Covington & Burling.

Speaking
of Covington & Burling, Lanny Breuer worked at Covington along with
Attorney General Eric Holder.Their firm's largest clients were many of the Wall Street banks that
were involved in the securitization of mortgage debt that contributed to the
financial crisis.

According
to Reuters, Attorney General Holder and Lanny Breuer were expected to recuse
themselves (a functional impossibility) under federal conflict of interest
laws from Department of Justice decisions related to many of Wall Street's
largest banks.Of course they have
not admitted to doing so in any instance of which I am aware.[7]

Abacus and Such

Goldman's
Abacus scheme would fit into the most selective definitions of fraud. Goldman
invented Abacus, according to an SEC civil complaint and an investor, to fail
so that one of its largest hedge fund clients, Paulson & Co, could short
it.[8]In the meantime, Goldman sold Abacus
bonds to many other investors all the while allowing Goldman to take in large
investment banking fees from the sale and from the purchase. The problem is,
the investors were not aware that Goldman's largest hedge fund client along
with Goldman Sachs was betting against them and that as such Goldman Sachs may
have a conflict of interest in designing what went into Abacus.Goldman claimed that somewhere within
all the disclosure statements was a reference to all this.The Department of Justice
announced it would not seek any criminal fraud charges against Goldman.Goldman Sachs settled the civil suit
for $550 million, which is not a lot for a company that earns billions of
dollars per quarter.

On
November 28, 2011, Judge Jed S. Rakoff rejected what would have been the sixth civil settlement agreement between
Citigroup Global Markets Inc. and the SEC since 2003 for $285 million.Citigroup had sold $1 billion in
mortgage-bonds through a vehicle called Class V Funding III, without disclosing
that it was betting against $500 million of those assets-in essence offering
something to its customers and not disclosing that it would be betting against
its customers.The Department of
Justice was not about to seek criminal fraud charges against Citigroup either.

Civil
settlements between the SEC and other parties are alternatively called consent
decrees and they are a far cry from criminal prosecution. Nor do they deter
misconduct because no admission of wrong-doing is required and the fines are
pin money to the banks.

It
is in the public's interest to prevent fraud upon the market and to prevent the
type of financial engineering solely for the sake of fees that can lead to
catastrophic losses ultimately borne by society as a whole. The type of hyperleveraged machinations, not understood by the banks themselves that wind up privatizing profit and publicizing loss. The problem with selective prosecution
of financial crime or any crime, is that it undermines the very idea of
justice, whose force and majesty lie in its fair and unbiased application.When the Executive branch's justice
department seeks fines from banks which fees are so small as to be written off
as a rational and good cost of doing business, while simultaneously pursuing
prosecutions against smaller parties and the comparatively disenfranchised, it
is no longer dealing out justice.It is selectively doling out punishments to those not in its favor.@

The Optimist
thinks this is the best of all worlds.
The pessimist fears it is true

J. Robert
Oppenheimer

The prosecutor of
the late Aaron Swartz and Sisamnes have something to tell us about the purpose
of those who have the awesome task of administering justice. The power of the
prosecutor in modern times is absolute and as such unlike in the case of King
Cambyses and judge Sisamnes, unchecked when it is abused. All the more reason to ask at these times, what is the
purpose of prosecution? Is
prosecution in all instances moral?
And is prosecution the same as justice? In answer to the latter, in the case of Aaron Swartz, the
answer is resoundingly in the negative.
The prosecution of Aaron Swartz may have followed the letter of the law
and fit an omnibus catchall federal charge like wire-fraud, but it makes
mincemeat out of Justice. Aaron
Swartz's prosecution also highlights some of the many problems with our criminal
justice system.

One of the more
memorable stories in the fifth book of Herodotus' Histories takes place in the
sixth century BC and it tells the fate of judge Sisamnes.The Persian King Cambyses discovered
that Sisamnes had diverted justice and rendered a verdict in a case based upon
his acceptance of a bribe.King
Cambyses understood the majesty and power of justice and his retribution for
Sisamnes' abuse of it is unforgettable in its brutality.King Cambyses had Sisamnes stripped of
his flesh, while alive and used the strips of flesh to upholster the court's
judge's chair.But Cambyses'
retribution for the abuse of justice did not end there for he made Sisamnes'
son Otanes sit on the grisly judge's chair as he was made the replacement
justice with the lesson that he must always remember his father's fate when
administering justice.

There is no King
Cambysis to check the power of the Executive Branch's Department of Justice.
The criminal law and the office of the prosecutor was originally meant to
punish actual wrongdoing that would harm society and in so doing deter conduct,
intentionally and severely harmful to civil society- like murder, theft,
burglary, treason.The Executive
Branch and its Department of Justice is given wide latitude and immunity to
bring about justice.

Prosecutors have
an immense amount of power-nothing less than the full force and power of the
federal government and all its resources.The power of the prosecutor to charge and the power to offer plea
bargain sets the course of justice in America.Most people indicted by federal prosecutors are convicted
and most take plea bargains.But it is not a fair fight, not even if you can afford the best lawyers
money can buy because after all, a federal prosecutor has a theoretically
unlimited budget.

Most people who
take plea bargains are poor and contrary to what those ignorant of the legal
system would more comfortably believe, they are not necessarily guilty.Prosecutors use varying degrees
of coercion and intimidation in the process of plea bargains.They can threaten to increase the
counts in an indictment, demand higher sentences, or as in the Giuliani's
prosecution of Michael Milken, intimidate Milken's 92 year old grandmother,
threaten to indict your spouse, keep you locked up before trial, and add
obstruction of justice if your defense is anything other than continual and
literal silence by invocation of the Fifth Amendment.We have come along way from Torquemada and yet if you look
closely enough, not exactly far enough.

Aaron Swartz took
his life on Friday January 11, 2013.In the fall of 2011, his lawyer had tried to work out a plea bargain
with Assistant United States Attorney Stephen Heymann but was told that Swartz
would have to plead guilty to all 13 indictments and would also have to do jail
time.On Wednesday January 9,
2013, his lawyer tried again to work out some deal on the eve of trial and as
Swartz worried about the costs of his defense and having his friends be made to
testify- the prosecutor refused to budge.

Unceremoniously
on January 14, 2014, the United States Attorney who had brought charges against
Swartz (Case: 11-cr-10260), Carmen M. Ortiz, dismissed them citing his death as
the reason for her doing so.[1]Carmen Ortiz had filed a 13 count superceding
indictment of Aaron Swartz on September 12, 2012 charging him with wire fraud,
computer fraud, theft of information from a computer, recklessly damaging a
computer, forfeiture and aiding and abetting.[2]

Aaron Swartz
accomplished a lot in 26 years and one gets the impression he would have done a
great deal more.He was only 14
when he developed RSS and later co-founded Reddit.He was a powerful force in the fight to keep the Internet
free and free of government censorship.In 2008, he wrote a program that extracted twenty percent of the court
documents (all public records), on the government's PACER system and put them
online so that they would be available to the public for free.His death is a real loss and a sad
commentary on overzealous prosecutors who not once considered the importance of
their obtaining a win against the value of young Aaron's life and the actual
harm he had done.

While the
indictment appears facially solid, the charges are less so.The indictment charges theft because it
states that Swartz stole, "a major portion of JSTOR's archive of digitized
academic journal articles" through MIT's computer network.Yet, Swartz was a fellow at Harvard's
Safra Center for Ethics and in this capacity allowed to access MIT's computer
network-at least as a guest.If he
was allowed to access the network as a guest, then the allegation of computer
fraud and theft in using the network become vulnerable.Also, JSTOR had settled with Swartz and
did not want any part in prosecuting him criminally especially after they had
recovered their files from Swartz.JSTOR has also stated it would not have been a complaining witness in
this case.

The government
was able to allege wire fraud because JSTOR's computers were not in
Massachusetts-this fact is less meaningful considering that JSTOR did not want
to prosecute Swartz.Moreover,
wire-fraud does not translate well in the age of cloud computing because
information does not exist merely within a state line-its locations are
generally closely guarded and sometimes outside the jurisdiction of the United
States calling into question, which laws even apply.

Prosecutorial
Discretion in the Backdrop of Burgeoning Laws

Unfortunately,
the practice of administering justice has systemic fragility-at least from the
perspective of the Bill of Rights.Lawmakers hurriedly make new laws and federal agencies invent new
regulations that taken together give prosecutors more ways to prosecute
Americans.

Prosecutors in
turn are given an expanding arsenal of tools for use in prosecution on top of
their already unfettered and unchecked authority.Some prosecutions are entered into because they are high
profile.Many prosecutors like
Giuliani and Spitzer used high profile cases as stepping-stones for their political
ambitions.[3]
Congress and many states, cave to political and media pressures to "do
something" about virtually any adverse event, and in the process invent new
criminal statutes and environmental regulations at a relatively breakneck
speed.This of course results not
just in a stunning enlargement of the government's power over the individual
(there is no commensurate enlargement in a person's Constitutional rights), but
a dilution of Federal power to enforce important criminal laws.Another consequence is the invitation
to abuse the power of the prosecutor to select which criminal statutes to
enforce and on whom to enforce them.The power of the prosecutor in America has never been
greater than it is today because of the greater resources of the federal
government and the sheer volume of criminal statutes and criminal offenses,
which is greater than it has ever been.

In an actual
case, I came across a multi-state drug dealer, who had been well represented by
an experienced defense lawyer and who had trafficked in kilograms of cocaine
never even got indicted.He walks
free without being indicted because a prosecutor allowed him to escape decades
of federal jail time in exchange for ratting out his co-conspirators.He even went on to be awarded
multi-million dollar contracts with the City of Chicago. Arguably, it is
alright that the drug dealer walks away free because the government was able to
prosecute at least two of his colleagues.

A crime is a
crime is a crime-or as Carmen Ortiz was once said about her indictment of
Swartz, "Stealing is stealing whether you use a computer command or a crowbar,
and whether you take documents, data or dollars...It is equally harmful to the
victim whether you sell what you have stolen or give it away."Or is it?

When a drug
dealer peddles pounds of cocaine from New York to Chicago and never gets
indicted, can anyone argue that no one was harmed?By contrast, who was actually harmed in the case of Aaron
Swartz?Why was it so much more
important to make him a felon and place him in jail for 35 years?

What content from
JSTOR did Aaron Swartz give away for free much less sell?

All
guarantees of individual liberty and freedom protected by the United States
Constitution under due process, equal protection and the presumption of
innocence have remained as they were written by the Constitution's drafters in
the first fourteen amendments, yet the reasons the Government may use to
exercise it power to deprive its citizens of their liberty have grown several
hundred thousand fold.This
would be as if instead of every side getting one chance at bat in a baseball
game, one team would get ten thousand chances at bat for every single time the
other team went to bat.

The
Government has hundreds of thousands of ways to deprive an American of his life
and liberty, and yet the number of amendments protecting your civil liberty
have remained the same.

If
you think that following the law is simple and you will never run afoul of it
and all this I write is pablum, you do not know the law.Keep in mind that federal law touches
upon every facet of an American's everyday life.All Americans engage in conduct, which falls under the
penumbra of use of the United States wire or mails.Americans are regulated by a myriad of laws, at times
obscure, and yet their ignorance of them offers no protection.

The
federal government spends billions of dollars on prosecutions based upon
theories of strict liability for obscure crimes honored more in their breach
than by their rule because the crimes lack definition.There are many examples of obscure but
actual and costly prosecutions based upon relatively new criminal statutes:
Prosecution of four men for bringing lobsters back that were not packed
properly according to a foreign law (Lacey Act); prosecution of handicapped
elderly woman who had not trimmed her garden hedges that abutted a side street
to the required level of under two feet; criminal prosecutions of manufacturing
companies for not being able to label their products for uses, wholly
unintended by the manufacturer and not capable of being foreseen; growing
orchids according to laws of another country (Lacey Act); registering under
false name on Facebook or Myspace; filling out any federal form and making a
mistake; running out of gas in a blizzard and abandoning your snowmobile, the
list of actual prosecutions is much longer.

To
put this in perspective, in 1790 there were about 6 crimes in America, treason,
piracy, murder, maiming, robbery and counterfeiting.In 2011, there were over 4,500 Federal crimes and hundreds
of thousands of regulations whose breach would incur criminal penalties.Congress invents a new crime on average
every week for every week of the year.[4]Congress is not however, simultaneously repealing existing
bad, redundant or conflicting criminal laws.Basic crimes like murder, robbery and theft are regurgitated
into new forms, but what is far more worrisome than the explosion of Federal
legislation, whose reach touches every aspect of everyday life, is the
invention of crimes lacking any wrongful intent-this phenomenon is called,
overcriminalization.

There are steep
economic costs in overcriminalization but the injustice of criminalizing and
prosecuting innocuous conduct is far more disconcerting. This said, the economic costs are staggeringly immense in terms of the
growth in the Federal prison population and the tens of millions of dollars per
case for the cost of high profile prosecutions based upon amorphous statutes,
as in the trial of a Martha Stewart, Roger Clemens or even a Lord Conrad
Black.

There
is a culture of prosecution that regards conviction as a benchmark for success
to be rewarded with re-election and advancement, even to the Judiciary.Along with plea-bargainning (something
never envisioned by the Constitution's drafters) we seem to be more concerned
with securing convictions than making sure the actual guilty are punished and
that the innocent and disenfranchised are never placed behind bars in an
already over-crowded and expanding prison population.

Prosecutors
often play to the media and the media affects high profile cases to the point
of driving prosecutions and hastening indictments-making a circus side-show of
the justice system.If they get it
wrong and destroy lives in the process, as so often happens in the prosecution
of vague statutes, prosecutors are never held accountable because of absolute
and qualified immunity.There is
effectively no check or balance on the powers of the prosecution.

Things
like the presumption of innocence are tossed aside for ratings or marketing for
prosecutors with political ambitions.Very much akin to the idea that there is no such thing as a bad arrest
or a bad conviction, the culture of prosecution measures success by the number
of convictions-it is very much a numbers game-unless of course a very high
profile defendant comes along.What suffers in all of this the equal administration of justice.And let us make no mistake about it
Aaron Swartz was a high profile defendant.

Another
contrast to Aaron Swartz's prosecution within the same year is a notable
non-prosecution and also of an high profile figure- Jon Corzine.Corzine engineered the eighth
largest bankruptcy in United States history and caused over $1.2 billion in
customer funds to go missing when MF Global was supposed to keep their customer
funds safeguarded, segregated and not touch them.Mr. Corzine, like the drug dealer, was never indicted and
never will be.He did not fight
against government censorship or control of the Internet, he was not unlike
Swartz determined to change the world-he was one of the largest campaign donors
to a sitting President and a close friend of the Chairman of the SEC.

At
the same time that the Department of Justice began its indictment of Aaron
Swartz, it announced it would not prosecute Jon Corzine.You must also keep in mind that
prosecutorial discretion is not always discrete.@

[3]It is the coolest of ironies that
Spitzer was indicted because he asked a bank teller not to put his name on a
wire transfer (a request that would have meant violating anti-money laundering
laws)-the same action he had prosecuted so many people of doing.

Last
week it was announced that the United States Department of Justice and the
Securities and Exchange Commission would not seek any criminal charges against
Goldman Sachs or for that matter the executives of MF Global including its CEO,
former United States Senator Jon Corzine.
This likely surprised many people who still read the news, but actually infuriated no more than three people among them... and they were probably on the verge
of becoming unhinged anyway. Most
people realize that while economists look for optimized states whose existence
is perfectly beyond dispute within their own models...optimized models of the
actual economy and democracy for that matter, exist only in the Great Books...
and many other books. In point of
fact, the discontents of oligarchy are numerous. While economists may not spend much time successfully
modeling the real world-perhaps in part because there are no repercussions for
their being in error, catastrophic events happen in the real world and are not
modeled or anticipated by any economist. Recent events like the decision to give Jon Corzine
and MF Global a pass are legitimate examples of the role of money in politics
and in the law.

Henry
Adams sort of foresaw the events of last week. Henry Adams had a privileged perch from which to view the
dilemmas of American democracy as he was the great grandson of the second
American President John Adams and grandson of our sixth President, John Quincy
Adams. There are certain scathing
critiques of politics that have always attracted me to Henry Adams-in the same
way I was drawn as child to the diatribes of Cato the Elder. For example, he regularly wrote about
the mortal danger to American democracy manifested by the role of money,
especially corporate influence and how its tendency to corrupt the political
system, would be the country's ultimate undoing. In writing about the corruption of the Erie Railroad for the
Westminster Review in 1870, he described corporate influence growing to the point of
being unchecked,

"swaying
power such as has never in the world's history been trusted in the hands of
mere private citizens,...after having
created a system of quiet but irresistible corruption-will ultimately succeed in directing government
itself. Under the American form of
society, there is now no authority
capable of effective resistance."

He
was also disturbed by the party system of politics in America and saw it to be
willing to sacrifice principle for accommodation. This theme comes out in his book, Democracy. In Democracy the idealistic and hyper-principled heroine, Madeleine Lee is
courted by the far more practical and ambitious Senator Silas P.
Ratcliffe. Madeleine decides not
to marry Ratcliffe though it seems that he gets the better of her in almost all
their arguments about politics.
Ratcliffe has aspirations to the White House and argues that moral
authority comes from his political party the party with which he will on principle never disagree, "that great results can only be
accomplished by great parties, I have uniformly yielded my own personal
opinions where they have failed to obtain general assent."

Many
of the books exchanges between Madeleine and Ratcliffe find Madeleine losing
the argument. She prefers to
remain single and reject Ratcliffe and Washington at the end of the novel as
she is determined to return to her philanthropic works saying, "The bitterest
part of this horrid story...is that nine out of ten of our countrymen would say I
had made a mistake." And they
still would. I confess I see
myself in Madeleine but one who must stay, without leaving, just out of an
insatiable curiosity to observe all that will happen.

Citizens United v. FEC and the Judiciary

Money
has always played a role in politics.
Any discussion of the role of money in politics, judicial elections or
law enforcement in 2012 has to consider the United States Supreme Court's
January 2010 decision in Citizens United v Federal Election Commission in which the Court ruled that
political spending is a form of protected speech under the First Amendment. Citizens United allows corporations and unions to
spend money to support or denounce candidates in elections through ads. This is a titan of a case, perhaps
unrivalled in its potential to alter the face of representative government in
the United States because of the way that most people who vote decide on a
candidate-they watch or listen to broadcast media advertisements. However, Citizens United did not alter much of the
McCain-Feingold campaign law, which still regulates corporate donations to political
parties and candidates. Nor does
the case affect political action committees or PACs, which can contribute
directly to candidates.

Perhaps
the greatest impact of the Citizens United decision will be in the election of state judges. Judicial independence at one time meant
independence from the Crown. Since
then the term judicial independence has come to mean the expectation (however
well grounded or not) that when dealing with the justice system, a person can
expect a member of the judiciary free from the appearance of personal, monetary
or political bias in the outcome of the case. This mirrors the all important principle stated in Article
40 of the Magna Carta, "To no one will we sell, to one will we refuse or delay
right of justice."

More money spent on judicial elections, it is
feared, will give rise to the impression that justice is for sale very much
reminiscent of John Grisham's book, "The Appeal," wherein a billionaire CEO
buys himself a state supreme court justice who rules in favor of his company on
an appeal. Grisham's book is
eerily like the true story of Supreme Court of West Virginia Justice Brent
Benjamin who ruled in favor of the $3,000,000 campaign donor, Don Blankenship,
the CEO of A.T. Massey Coal in a case involving a $50,000,000 verdict. The United States Supreme Court ruled
that Justice Benjamin ought to have recused himself in the case Caperton v.
Massey.

There
is however one place where Citizens United may have a salutary effect on the judicial
system. In Chicago's Cook County,
Illinois the slating of judges is militantly political and based not on merit per se but on a candidate's payment of $25,000 to one of the
members of the Judicial Slating Committee of the Cook County Democratic Party. Judges that are slated, almost
invariably win. Citizens United cannot but have a salutary effect
here because it is difficult to imagine a worse system for picking judges
anywhere.

The Imperial Presidency and
Money

James
Madison was a staunch advocate for the separation of powers between all three
branches of government. The
authors of a recent book, "The Executive Unbound: After the Madisonian
Republic," by sitting Seventh Circuit Court of Appeals Judge Richard Posner and
an Adrian Vermeule from Harvard Law argue that the separation of powers is a relic of the past and largely beside the point. Without getting into questions of judicial activism and the
phenomenon of hyper-opinionated sitting justices, they are actually right
from an anthropological perspective.
They are right in so far that the Executive Branch has
become, with the passage of the Administrative Procedure Act and sweeping acts
of legislation such as Dodd-Frank and now the Patient Protection and Affordable
Care Act, the most powerful branch of government. The Executive has created so many branches, departments and
agencies under its purview, most with rule-making ability-that its power has
become tantamount to that of an imperial monarchy.

However,
Justice Posner because he seems only to view the world through the lense of a
relentlessly pragmatic cost-benefit, economic analysis, draws at times
predictable but disturbingly simplistic conclusions. In their book, Justice Posner and Dr. Vermeule
acknowledge the relative impotence of the other branches to keep up with or
check the Executive and go on to assert that this does not much matter because
Presidents are checked by elections, "liberal legalism's essential failing is
that it overestimates the need for the separation of powers and even the rule
of law."

In
other words, just because Presidents are above the law, it does not matter
because they will be checked by the rule of politics-they will be voted
out. This is startling simplistic
and weak logic because it assumes an efficient marketplace, with equal participants
and perfectly symmetrical information.
It also allows for the interpretation of the Constitution based upon a
pragmatic economic analysis completely at war with the absolute first
principles and "inalienable rights" held sacred by the Founding Fathers and all
the state legislators that ratified the Constitution.

This
is also where money comes in.

In
his run for President in 2008, President Obama spend over $730 million and is
expected by Reuters to raise $1 billion for 2012. Spending for the 2012 election for all parties and
candidates could, according to one estimate, top $9.8 billion in large part
because of spending by super PACs.
Yet almost 25% of super PAC money comes from just five donors, Harold
Simmons (pro-Romney) , Sheldon Adelson (pro-Romney), Peter Theil (pro-Ron
Paul), Bob Perry (pro-Romney now) and Jeffrey Katzenberg (pro-Obama).[1]

If
money affects voting and elections, then according to Posner's logic, the
people who will actually exercise the rule of politics and check the Executive
Branch are to be these handful of businessmen and others like them. According to the Center for
Responsive Data, 3.7% of the contributors to super PACs account for 80% of the
money raised-46 donors have given in excess of $67,000,000.[2]

Money and Prosecutions

In
the case of MF Global and Jon Corzine, Jon Corzine has been one of President
Obama's elite bundlers in 2011 and 2012.
He campaigned heavily for President Obama when he was governor of New
Jersey and has held private fundraisers for President Obama in his home even
after MF Global went bankrupt and $1.6 billion of customer funds went missing
in October 2011. It was announced
last week that he is unlikely to face any criminal charges.

Contrast this to the Department of Justice's handling of the same violation of the Federal rule requiring the segregation of customer funds in the matter of Peregrine Financial Group. $215
million of customer funds were discovered to be missing from customer
segregated accounts in July 2012 at Peregrine Financial Group. Russell Wasendorf Sr was arrested and
criminally charged later that month. Same act-missing customer funds-but far disparate
prosecution.

Remember
that in the futures industry, the key difference between futures commissions
merchants ("FCMs") like Peregrine and MF Global and securities brokerages is
that FCMs, unlike securities brokers, are required by law to keep their
customer fundssegregated
from the FCM's own funds. It
is in this way that FCMs have been able, with comparatively few exceptions, to
ensure that customer deposits are completely protected from all losses an FCM
may incur due to its own proprietary trading. Before MF Global, the requirement that FCMs segregate
customer funds completely from their own funds largely prevented FCM customers
from losing money due to an FCM bankruptcy

In my first article on MF Global, I
suggested that the $1.2 billion missing from customer segregated funds may have
been incurred due to over-leveraged positions in European sovereign debt that
coincidentally took a dramatic turn for the worse (as they did in fact as yield
curves doubled rapidly in some issues) during the last weeks of October, and
that funds were transferred to cover margin in customer funds held in European
debt. There is a scenario
that nothing illegal would have occurred because CFTC Rule 1.25 had been
amended to permit the investment of customer segregated funds in foreign
sovereign debt. Keep in mind that
this rule was amended by Jon Corzine's lobbying of Commodity Futures Trading
Commission ("CFTC") Chairman Gary Gensler, who is a friend and colleague of Jon
Corzine.

An alternate illegal scenario is that MF
Global may have engaged in some late stage embezzlement of customer funds that
were supposed to be segregated from MF Global's accounts and never commingled
with any other funds.[3] One way this may have occurred is
if the funds were transferred out of customer segregated funds for a legal purpose
but without the customers' meaningful consent or, more likely, with an intent
to deceive the customer.

If
MF Global transferred customer funds out of segregated accounts as a loan to MF
Global to cover margin calls in existing positions in sovereign debt,
(perfectly legal)[4], it may
however, be fraud and intent to deceive on its part if MF Global knew it could
not repay the money. This fraud
may have occurred if MF Global knew (and it would be interesting to argue how
it did not) that it sought to legally borrow from customer funds, knowing that
it was de facto
insolvent and could not replace the money.

During
Senate and House hearings on MF Global, Terrance Duffy, the CEO of the Chicago Mercantile
Exchange contradicted Corzine's testimony and stated that the CME's
investigation of the MF Global matter revealed the existence of emails between
MF Global's assistant treasurer and Jon Corzine. These emails where contrary to what Corzine told
Congress and suggested that Corzine had in fact authorized the transfer of customer funds out of customer
accounts-the funds that went missing. We also know that while Jon Corzine claimed he knew
nothing about the financials at MF Global, he was peddling them to Interactive
Brokers as he was trying to broker a last minute sale of MF Global to Interactive Brokers--in other words, he had to
have been extremely familiar with MF Global's financials during the exact time
period he claims to Congress to know nothing of what was happening.

We
still do not know everything that really happened at MF Global because the
Department of Justice has not yet decided to grant any immunity to the one person
who would be their chief witness in the matter, the Assistant Treasurer. The Assistant Treasurer is represented
by Reid H. Weingarten, who is as luck would have it, is one of United States Attorney
General Eric Holder's best friends.
Some could say they agreed
to let the clock run out on this one.

From
a purely economic cost benefit analysis, Jon Corzine's raising in excess of
$500,000 for President Obama in 2012 alone was the smartest money he ever spent
and appears to have bought him justice in the sense of a reprieve from the CEO
of Peregrine's fate.

What
about Mr. Adelson? The billionaire
casino magnate is being investigated for possible violations of the Foreign
Corrupt Practices Act, money-laundering and bribery. Perhaps contributing by some accounts close to $100 million
towards Mr. Romney's election would ensure a stop to the pesky Federal
investigators. If so, this would
be money entirely worth spending.

This
brings us to the last bit of news from last week that Goldman Sachs would not
be investigated for criminal wrong-doing in connection with mortgage crisis and
certain deals like ABACUS.

This
Justice Department and SEC have gotten many investment banks to execute settlement
agreements with them including Goldman and Citigroup-essentially selling "get
out of jail cards." Are these settlement agreements, as the Judge Rakoff and
Bloomberg's Jonathan Weil have asked, merely considered the "cost of doing
business" or some part of a transaction tax on offending financial titans?[5]

If
it were in the public's interest to prevent fraud upon the market, then fines
should be significant enough to actually deter illegal conduct. If not, prosecutions should be endured
and convictions gotten.
The historic role of punishment in the criminal justice system has not
been just punishment, but deterrence.
Having Citigroup or GS pay $285 million is pin money to banks with
quarterly revenue in the billions of dollars-the "cost of doing business" is
not a deterrent to anyone but more like the cost of a municipal parking
sticker to the average Joe.

What
is problematic about bank settlements is that smaller market participants
cannot afford to pay for "get out of jail cards" and because the costs of
prosecuting anyone other than an investment bank are less, smaller participants
are actually prosecuted and do get jail time. Peter Boyer and Government Accountability President Peter Schweizer have written about how justice is for sale in Mr. Eric Holder's Department of Justice pointing to the fact that despite President Obama's claims to represent the 99%, Department of Justice "criminal prosecutions are at 20 year lows for corporate securities and bank fraud." [6] Given the correlation between campaign contributions (admittedly protected speech) and selective prosecutions, the 20 year low in bank fraud prosecutions is unlikely to change with either political party.

Consider the money. Goldman
Sachs employees were the second largest single contributor to President Obama
in 2008 contributing $1,013,091.[7]
Goldman's employees are the
largest single contributor to Mr. Romney in the 2012 election cycle having
donated $636,080 by the end of the last quarter.[8]
Goldman Sachs is also one of
the largest clients of Mr. Eric Holder's lawyer firm Covington & Burling.

Money
has always played a part in politics and it is rational for everyone with a
stake in the political process to participate. But not all participation is equal-not even close. The odds of one vote ever making a
difference in a Presidential election are between 1 in 10 million and 1 in 100
million-depending upon the state in which you live. Voting only matters in the aggregate but money seems to
matter more in terms of affecting action after election. Above all, justice must never be for sale because as Cato the Elder and many others have pointed out throughout history the selling of justice, like the selling of indulgences, is an attribute of a decaying and dying political system.

What is disconcerting is
that mere principles, be they the adherence to ideas like freedom and
individual liberty or the idea that you are secure in the sanctity of your own
home, are always bound to be under-represented in the electoral process and as
such destined to play the underdogs.
At one point in Democracy, Madeleine asks the impressive Ratcliffe, "Surely...something can be
done to check corruption. Are we
for ever to be at the mercy of thieves and ruffians? Is respectable government impossible in democracy?" Ratcliffe's reply is haunting, "No
representative government...can long be much better or much worse than the
society it represents. Purify
society and you purify the government.
But try to purify the government artificially and you only aggravate
failure. @

[4]Remember CFTC Rule 1.25 which had
been amended to allow the investment of customer segregated funds in foreign
sovereign debt, was amended back after the fall of MF Global to disallow the
investment of customer segregated funds in foreign sovereign debt.

Does anyone police the regulators? Are more regulators needed to police regulators for conflicts of interest that at least superficially would seem to affect their judgment? And why must we as a society perpetually add to a body of existing regulations just because we seem unable to effectively enforce the ones we already have? I ask all this in thinking about Gary Gensler, the current Chairman of the Commodity Futures Trading Commission ("CFTC"). There is a legal standard for causality, the "but for" rule. Under this legal standard, had Mr. Gensler not been involved with Jon Corzine, $1.2 billion in customer funds may not have gone missing. In hindsight, Mr. Gensler's conflicts of interest regarding MF Global required policing.

MF Global filed for bankruptcy in the amount of $41 billion on October 31, 2011 after a loss of confidence over the firm's $6.3 billion bet on European sovereign debt. Since then, while most of the missing $1.2 billion in customer funds has been located, in excess of $600 million in customer money remains missing. There are no guarantees, the commodity customers from whom most of the money was lost, will regain their money. As of this writing, it is still not known what happened to the lost money nor why it has remained unaccounted for three months.

I suggest a possible conflict of interest between Jon Corzine and Mr. Gensler based upon their friendship, and a common political and professional involvement. What follows is a laundry list of connections-the applicability to MF Global comes later. For starters, Jon Corzine was the Chairman of Goldman Sachs during part of the eighteen years that Gary Gensler worked at Goldman Sachs. Mr. Gensler donated $10,000 to Corzine's campaign for governor of New Jersey. They worked together in Congress when Corzine was a Senator and Mr. Gensler a Senate aide. They worked closely together drafting large portions of the investor protection act, Sarbanes Oxley, while Corzine served on the Senate Banking Committee. In 2010, Corzine invited Gensler to lecture at Princeton about financial regulation and Gensler also spoke to the audience assembled about his friendship with Corzine. Gensler donated $300,000 to the prominent Democratic candidates including President Obama and Hillary Clinton. Corzine has been one of President Obama's elite bundlers, this past April 2011, alone holding an exclusive fundraiser from his Manhattan apartment where he was able to pass the hat around for more than $500,000. Gensler authored much of the Dodd-Frank Act and analysts like Sandler and O'Neill Partners wrote that they expected Corzine's contacts in Washington as he took over as CEO of MF Global in 2010 to help him "navigates a shifting regulatory environment."[ 1]

Conflicts of interest are ubiquitous on Wall Street and deserving a voluminous treatment. The tension between principal and agent is entrenched and accepted.

But is not just on Wall Street and not just between the principal and agent that conflicts of interest reside-they are everywhere-in politics, between the State and the governed, the employee and the employer, at credit ratings agencies, really at some level in every aspect of our public and personal life. It seems that government agencies are inclined to grow and expand seemingly without limit, an interest or will to power, entirely distinct from merely serving the governed well. I am conflicted between my love for pizza and bikinis. What is problematic about conflicts of interests are that among competing interests, something has to give and what usually does is the fiduciary duty of either the agent of the principal. No public figure and no investment bank can be all things to all competing interests- there is often a tension between shareholder profits, trader profits and a customer's best interests. Contrary to the silly ideas that many belch out, there is no simple cure either. What is the evidence of a conflict of interest, if any, in Mr. Gensler's role as Chairman of the CFTC and the fall of MF Global?

Bankruptcy proceedings under conflicting regulatory regimes.

As if things have not been bad for MF Global's customers since October 2011, they became much worse when two days ago on February 1, 2012, Judge Martin Glenn of the United States Bankruptcy Court for the Southern District of New York ruled that the commodity customers of MF Global (the majority of people whose money was lost) do not have any priority over other creditors in the firm's bankruptcy proceedings. Had the customers with segregated accounts at MF Global been given priority status, they would be assured of receiving all of their missing money, before any other creditors, like JP Morgan Chase were paid.

There are two dueling regimes under which MF Global's assets in bankruptcy could have been adjudicated-one for securities broker dealers and one for commodity brokers. MF Global was both a broker-dealer and a commodity broker. Broker dealers are liquidated in accordance with the provisions of the Securities Investor Protection Act ("SIPA"), and a SIPC-appointed trustee oversees the liquidation.

MF Global was also a commodities broker or futures commission merchant ('FCM"). Commodity brokers are liquidated in accordance with the provisions of Subchapter IV of Chapter 7 of the U.S. Bankruptcy Code.[2 ] According to this bankruptcy regime, customer funds must be identified, kept separate and are not made available to pay for a firm's obligations to other creditors of the FCM. Under this second regulatory regime, a trustee overseeing the liquidation in bankruptcy of an FCM must apply the CFTC's Regulation part 190 (CFTC derives its authority to make this rule under the Commodity Exchange Act or CEA), which holds that commodity customer must receive priority over all other creditors of an FCM in the event of bankruptcy.[ 3]

Judge Glenn wrongly decided that the operative bankruptcy regime for MF Global should be that used for a broker-dealer rather than a commodities broker. Judge Glenn was able to disregard or may not have been presented with the fact that most of MF Global's business was in commodities and not securities. According to one of my sources, MF Global had 50,000 futures customer accounts and 400 customer accounts in securities.

This ruling is made worse when one considers that many of the customers whose missing money totaled $1.2 billion were small traders who invested with MF Global perhaps because they were not able to open accounts with larger institutions.

Did Gary Gensler play a role in deciding upon an SIPA bankruptcy a decision that would harm thousands of commodity account holders and forever damage investor confidence in the commodity markets- in lieu of choosing a bankruptcy regime based upon the CEA and CFTC's Regulation part 190? There are those like the blog, "MFGFACTS," who would argue that he did just that but the evidence cited appears to be invisible.[ 4 ]

Before Gensler recused himself from the CFTC's investigation of MF Global, he had participated in two closed-door CFTC meetings on October 31, 2011 and November 2, 2011-the purpose of both meetings was according to Bloomberg News, MF Global's bankruptcy.[5 ] Senator Pat Roberts sent Gensler a letter on November 10, 2011 demanding to know what was discussed between Gensler and his staff regarding MF Global's bankruptcy during these meetings.[6 ]

But to be fair, no one has yet presented any actual proof that Gensler believed the appointment of a SIPC trustee (an automatic occurrence I think in the event of the broker dealer going bankrupt) would preclude the utilization of a CEA based bankruptcy proceeding. If some deal was struck as a favor to institutional creditors like Goldman Sachs or JP Morgan Chase over small farmers in Iowa, no proof has come to light.

The CFTC to its credit, filed a reply brief on January 18, 2012 urging the bankruptcy court to apply the bankruptcy provisions of the CEA and CFTC that would give MF Global's commodity customers priority over all other creditors and warning that a prior filing by MF Global's bankruptcy Trustee Louis Freeh contained, "errors and misstatements of law that, if accepted, may inhibit commodity customers from recovering their property."[ 7]

Gensler differs to Corzine's lobbying and MF Global allowed to make bets on European debt

The stage was set for MF Global on February 3, 2005, when the CFTC published proposed amendments to its Rule 1.25, which governed what types of investments an FCM may make of customer segregated funds. Before 2000, FCMs and designated clearing organizations ("DCOs") were only permitted to invest in United States debt (including municipal and state debt). On May 17, 2005, the CFTC published final rules that further amended Rule 1.25 to allow for the practice of FCMs using repurchase agreements called "repos" with customer funds. The size of the repo market in the United States alone is $1.6 trillion.

A repo is simply the sale of a security (typically a government debt) tied to an agreement to buy the securities back later. A reverse-repo is the purchase of a security tied to an agreement to sell back later. Repos are essentially loans secured against a security. The interest rate received is called the repo rate. The party that sells a security agreeing to buy it back in the future at a higher price later is engaging in a repurchase agreement. The party that agrees to buy the security and sell it back in the future is engaging in a reverse repo.

Corzine took over as CEO of MF Global around March 2010. According to its former risk manager, Michael Roseman in his testimony yesterday before the House Oversight Committee, by October 2010, MF Global bets on European debt were $4 billion. The use of repos by MF Global would have permitted the firm to leverage customer deposits, although it is unknown that they did. However, leverage of 30:1 or greater, through the use of repos would have resulted in larger losses if the repos were in sovereign European debt. This does not mean that repos are per se instruments of financial destruction.

Repos are part of what is the shadow banking system. I would define shadow banking as simply the collection of unregulated activities (repos, credit default sways and collateralized debt obligations, etc) engaged in by regulated and unregulated entities. Shadow banking like is very like traditional banking (other than existing regulations do not address it) and it provides a very important supply of short-term credit.

CFTC Rule 1.25 governs the investment of customer funds by an FCM.

(a) Permitted investments. (1) Subject to the terms and conditions set forth in this section, a futures commission merchant or a derivatives clearing organization may invest customer money in the following instruments (permitted investments):
(i) Obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities);
(ii) General obligations of any State or of any political subdivision thereof (municipal securities);
(iii) General obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities);
(iv) Certificates of deposit issued by a bank (certificates of deposit) as defined in section 3(a)(6) of the Securities Exchange Act of 1934, or a domestic branch of a foreign bank that carries deposits insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes or bonds;
(vii) General obligations of a sovereign nation [emphasis added]; and

In late 2010, the Commodity Futures Trading Commission -- one of MF Global's regulators -- proposed changing one of its regulations, known as rule 1.25, to limit the kinds of investments that firms like MF Global could make using their customers' idle funds, including risky debt of sovereign nations. It was Corzine himself who lobbied for the change in Rule 1.25 to allow for customer-segregated funds to be held in foreign debt instruments.

On July 20, 2011, Corzine said, he "took part" in a conference call with CFTC Chairman Gary Gensler in which MF Global executives made clear their opposition to any changes in rule 1.25. On the call, Corzine said, he argued that the repo transactions with other broker-dealers should be permitted "because such transactions could be beneficial to" firms like MF Global.

Later that same afternoon, Corzine and his General Counsel at MF Global again called the CFTC and again reiterated their view that rule 1.25 should be left alone. Gensler complied.

Had Mr. Gensler changed CFTC Rule 1.25 as he was supposed to do after the passage of Dodd-Frank and not given into lobbying by Corzine, I would not be writing this and $600 million in customer money would not still and inexplicably be lost.

In an irony almost too much to bear, Commissioner Gensler told Reuters this past Wednesday that he, "has ordered an extensive review of how futures brokerages are regulated, following the collapse of MF Global three months ago." Is this like his recusal this past November anything other than a belated grasp at having clean hands or another smokescreen?

Why now impose more regulation on an industry that he and Corzine single-handedly played a role in damaging perhaps (though I hope not) beyond complete repair. MF Global would not have gone bankrupt but for Gensler and Corzine choosing not to amend Rule 1.25, an amendment that would have wholly prohibited MF Global's European bets. Congress should think clearly and focus on Corzine and Gensler's conflict of interest instead of inviting C-Span to broadcast itself yet again, as it did today, chasing a stream of red herrings for causation in the form of credit ratings agencies, credible risk officers and the exchanges.@R. Tamara de Silva

Chicago, Illinois
February 3, 2012

R. Tamara de Silva is an independent trader and securities lawyer

Any questions about this article should be directed to tamara@desilvalawoffices.com

Last Thursday December 15, 2011 was MF Global Holdings Ltd.'s and MF Global Inc.'s Chief Executive Jon Corzine's third time to testify before Congress. He may not have faired all that well in light of Chicago Mercantile Exchange Group Chairman Terrance Duffy's testimony on December 13, 2011, which seemed to contradict Corzine's previous testimony. Corzine adjusted his testimony on December 15, 2011 to account for the seeming contradiction. However, how well Corzine may have done to avoid perjury or any role in a possible fraud remains to be seen. A closer examination of Corzine's testimony and the events leading up to MF Global's bankruptcy on October 31, 2011 suggests problems. If there is any purpose to be achieved in having Corzine testify again, lawmakers should focus their questions towards the failed purchase of MF Global by Interactive Brokers and all customer agreements, including emails between MF Global and account holders leading up to the purported transfers of $175 million and $700 million in as yet missing customer segregated funds and the firm's use of a type of repurchase agreement.

Were the Transfers Legal?

In my first article on MF Global, I suggested that the $1.2 billion missing from customer segregated funds may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (as they did in fact as yield curves doubled rapidly in some issues) during the last weeks of October, and that funds were transferred to cover margin in customer funds held in European debt. In this scenario, as I suggested, nothing illegal would have occurred because CFTC Rule 1.25 had been amended to permit the investment of customer segregated funds in foreign sovereign debt.

Moreover, if the money was transferred legally and without any fraud, but simply lost in the market, there may not be any right to recover the money by MF Global's customers in bankruptcy proceedings. The use of customer segregated funds for margin payments on repo-to-maturity ("RTM") transactions are not illegal and hence unlikely, without anything else, to be recoverable in bankruptcy.

An alternate illegal scenario is that MF Global may have engaged in some late stage embezzlement of customer funds that were supposed to be segregated from MF Global's accounts and never commingled with any other funds. [1] One way this may have occurred is if the funds were transferred out of customer segregated funds for a legal purpose but without the customers' meaningful consent or, more likely, with an intent to deceive the customer.

MF Global was permitted to invest customer funds, and borrow customer funds so long as the dollar value of the funds taken from the customer segregated accounts remained the same-the accounts were kept intact. For example, if MF Global used customer funds by transferring a specific amount of money out of customer segregated accounts; it was required to simultaneously deposit something of equal value in these accounts to equal the dollar value of what had been taken out.

If MF Global transferred customer funds out of segregated accounts as a loan to MF Global to cover margin calls in existing positions in sovereign debt, (perfectly legal) [2], it may however, be fraud and intent to deceive on its part if MF Global knew it could not repay the money. This fraud may have occurred if MF Global knew (and it would be interesting to argue how it did not) that it sought to legally borrow from customer funds, knowing that it was de facto insolvent and could not replace the money.

In other words, an acceptable use of customer segregated funds for margin payments may not exist if at the time MF Global made the transfers, it was insolvent or in the midst of a crisis where insolvency was around the corner to be seen. Even if MF Global asked for and obtained the consent of its of customers, or consent was not required according to customer agreements, and it legally borrowed the money from customers by replacing it with other collateral (collateral such as commercial paper, as permitted by CFTC Rule 1.25), the transfers would still be illegal because MF Global would be deceiving its customers-knowing it was already insolvent. Even though the rules likely permitted the replacement of funds with other collateral (and the collateral was used) MF Global's actions are arguably illegal because they were deceiving their customers knowing they would not be able to make the customers whole. Meaningful deception like this would be fraud and embezzlement in which case, the funds could be clawed back in bankruptcy proceedings-Please note that I am speculating a bit in specific statements about bankruptcy proceedings and do not specialize in this area of law.

Changing testimony or selective recall?

On December 8, 2011, Corzine testified before the House Agriculture Committee that he had "no idea where the money is" and that "I know I had no intention to ever authorize the transfer of segregated moneys. I know what my intentions were."

On December 13, 2011, Corzine testified that, "I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue."

On December 13, 2011 Terrance Duffy testified before the Senate Agriculture Committee. In Mr. Duffy's testimony he said that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global's broker dealer operations, that Corzine knew all about the transfers and likely authorized them.

On Thursday November 15, 2011 Corzine repeated that he did not authorize any illegal transfers, pointing to his General Counsel and Treasurer as the people who would know about the transfers. However, he was able to recall the $175 million transfer enough to tell the Committee that Duffy likely meant a loan advance from customer segregated funds to MF Global's European operations. Remember that all his previous testimony was to the effect that he, "was totally stunned to learn customer money was missing...did not learn about it until October 30, 2011...etc"- in this context it seems a tad odd for him to suddenly develop a very specific recall about one event of October 28, 2011. Sadly, this was wholly lost on the Committee, which asked not one follow-up question.

In addition to Mr. Duffy's testimony that a MF Global back office employee said Corzine was aware of the transfers, the Committee alluded to evidence that the Chief Financial Officer of MF Global's North American operations (presumably Christine Serwinski) said that Corzine knew about the transfers. If so, there are at least two or more MF Global employees and officers who contradict Corzine's sworn Sgt. Shultz testimony.

Not being perfectly honest with FINRA

On December 8, 2011, Steve Luparello, the Vice Chairman of the Financial Industry Regulatory Authority ("FINRA") also testified before the House Committee on Agriculture about MF Global's collapse. According to Mr. Luparello, MF Global was not completely candid with the Chicago Board of Options Exchange ("CBOE") and FINRA. In late September 2010, MF Global assured both regulatory bodies that it did not have any positions in European sovereign debt.[3] MF Global did in fact have positions in European sovereign debt during this time but because according to GAAP accounting rules, positions held in RTMs are treated as sales and not liabilities, MF Global did not violate the law in hiding its credit and risk exposure to RTM, which are liabilities in the real, non-accounting world. Technically, MF Global was able to get away with it, at least for a time.

A little background may be helpful and a story of another failed firm, Lehman Brothers that generously indulged in a cousin of RTMs, the Repo 105. The Repo 105 was utilized by Lehman Brothers, among other firms that did not survive the last financial crisis including Washington Mutual, Northern Rock and some that did like Citigroup.

This is how it worked and how a liability (a loan) can be transformed into a revenue-generating event (a sale)...if you are an investment bank that is. Lehman entered into repo transactions with offshore banks. Lehman would sell (though actually a loan) a bundle of toxic assets such as sub-prime mortgages and dubiously collateralized debt obligations to the bank. This transaction is characterized on the books of Lehman as a sale. Lehman agrees to buy back or repurchase (hence the term 'repo') the toxic assets at a later date (maturity). In this way, Lehman moves loans and bad assets off its balance sheets towards the end of each financial quarter-removing liabilities dramatically improves a balance sheet- as if they do not exist. Then Lehman reports the sale as a revenue-generating event, in effect moving by way of example, $39 billion off its balance sheet in what is a liability, and reporting it as a sale of $39 billion. It is fraudulent twice over in that Lehman does not disclose on its financials that it has an obligation (a debt to buy back) to pay back the amount loan and it reports the loan as revenue.

In effect, this is what MF Global did with FINRA and CBOE. However, the regulators caught MF Global's exposure to European sovereign debt and told MF Global to keep substantially more money in reserves because of what FINRA identified in May 2011 as a $7.6 billion risk exposure. MF Global appealed to the SEC and because of the appeal process, it was only in August that FINRA and the CBOE were successful in getting MF Global to put up more money for its European debt exposure and utilization of RTMs.

An accounting error

Also on December 15, 2011, the oversight panel of the House Financial Services Committee released a CME Group document the CME had given to the government containing a detailed log of its dealings with MF Global between October 24, 2011 and October 31, 2011. According to this document, Christine Serwinski, the Chief Financial Officer for North America at MF Global, and its Assistant Treasurer, Edith O'Brien, told a Mike Procajlo, an exchange auditor at 1:00 a.m. on Oct. 31, 2011 that the customer money was transferred on Oct. 27 and Oct. 28 and possibly Oct. 26, 2011. "About $700 million was moved to the broker-dealer side of the business to meet liquidity issues in a series of transactions on Thursday, Friday and possibly Wednesday," Serwinski told Procajlo about eight hours before the firm filed for the eighth-largest bankruptcy in United States history.

Barely three days prior, on October 28, 2011, MF Global had submitted a statement to the CME showing that it had $200,178,912 in excess cash in its customer segregated funds as of the close of October 27, 2011.

On October 30, 2011, an official from the CFTC informed Procajlo that a draft statement of the value of MF Global's customer segregated funds, showed a deficit in customer segregated funds for the day ending October 28, 2011. MF Global's Assistant Controller, Mike Bolan and its General Counsel, Laurie Ferber said they believe the customer-funds deficit is "an accounting error." Ms. Ferber had told the CME on October 25, 2011 that rumors about problems stemming from MG Global's European debt trading were not accurate.

On December 15, 2011 Mr. Duffy told the House Committee that this so called accounting error was "a telling sign that regulators were being kept in the dark" about MF Global's customer accounts. What was Corzine doing during all of this?

Acquisition by Interactive Brokers

While the exchange was trying to get to the bottom of the accounting error, whose magnitude would not be revealed until the evening of October 30, 2011 as being $900 million, Corzine and other MF Global officials were trying to close a deal to sell MF Global to Interactive Brokers Group, Inc. On that same day, October 30, 2011, MF Global issued a press release at 6:00 p.m. announcing that it had reached a deal with Interactive Brokers.

Corzine as CEO of MF Global negotiated the potential sale of his firm to Interactive Brokers. The first question involved in any sale of a going concern involves the determination of an acquisition price. Corzine would have had to know what the assets and liabilities of MF Global were (the balance sheets) to even begin to negotiate a price. The deal was happening at the exact same time of the transfers.

It is beyond the bounds of credibility to argue that MF Global did not have regular if not daily accounting of cash balance sheets and that Corzine did not see them. If Corzine knew what the company was worth, during the very days in which at least $900 million in customer segregated funds was lost, he must have at a minimum known about the company's impending insolvency. How then could he not have known of the transfers?

In addition, as a matter of course in the futures industry, MF Global likely had to report the total daily amounts carried in segregated funds to the CME-it certainly had to do so from October 24, 2011 onwards. This computation is performed as a matter of course every single day at every futures broker.

Corzine's testimony before Congress would have us believe that hundreds of millions of dollars were moved around without the knowledge or approval of the MF Global's CEO and CFO all while the balance sheets were being scrutinized for an acquisition by Interactive Brokers, which Corzine spear-headed.

Corzine has sworn under oath that he did not know anything about the missing money until October 30, 2011. This is simply not possible.

Suggestions for House and Senate Committees

Further education about the industry is in order. Both the House and Senate soft-peddled the issues, and perhaps unintentionally avoided important questions and asked almost no meaningful follow-up questions, allowing Corzine to stretch the bounds of credibility in evasiveness. Further questioning should focus, among other things, on the representations made by MF Global to Interactive Brokers on October 24, 2011-October 30, 2011.@
R. Tamara de Silva
Chicago, Illinois
December 19, 2011

R. Tamara de Silva is a securities lawyer and independent trader

Footnotes:
1. http://www.timelyobjections.com/john-corzine/
2. Remember CFTC Rule 1.25 which had been amended to allow the investment of customer segregated funds in foreign sovereign debt, was amended back after the fall of MF Global to disallow the investment of customer segregated funds in foreign sovereign debt.
3. http://www.finra.org/Newsroom/Speeches/Luparello/P125233

Testimony before Congress today revealed that MF Global had illegally transferred $175 million out of customer segregated funds towards its European broker-dealer operations before it went into bankruptcy proceedings and very much under Jon Corzine's stewardship. On December 8, 2011 and again today before Congress, Corzine testified under oath that he was not aware of any illegal transfer. Today's testimony of Chicago Mercantile Exchange Group Chairman, Terrance A. Duffy suggests that Corzine did know about the transfer.

My last article on MF Global stated that $1.2 billion in losses may have been incurred due to over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October, or alternatively, that MF Global had engaged in some late stage embezzlement of customer funds that are supposed to be segregated from MF Global's accounts and never commingled with any other funds.[1]

It now appears that Jon Corzine may be the best example of the why it makes sense to invoke the Fifth Amendment if you are not inclined to be anything other than completely honest because you simply will not get away with anything other than complete honesty under oath. Corzine testified before the House Agriculture Committee December 8, 2011 and today before the Senate Agriculture Committee. Today, according to the testimony of Chicago Mercantile Exchange Group ("CME"), Chairman Terrance A. Duffy, Corzine may have lied.

In Corzine's December 8th testimony, he essentially hems and haws and states that he cannot recall much of anything, things were chaotic during the last days of MF Global, he was completely lacking in mens rea, would not have authorized any transfer of customer money out of segregated funds, does not have all the records after he resigned and certainly did not intentionally do anything wrong. Nothing other than attempting to mislead Congress and lying.

On December 13, 2011, Corzine testifies that, "I never directed anyone at MF Global to misuse customer funds. I never intended to. And, as far as I am concerned, I never gave instructions that anybody could misconstrue."

Also on December 13, 2011 Terrance Duffy, Jill Sommers, Commissioner of the CFTC and James Giddens, MF Global's bankruptcy trustee also testified before the Senate Agriculture Committee.

In Mr. Duffy's testimony he says that the CME has been conducting their own ongoing investigation of MF Global and discovered on December 10, 2011, after questioning a former MF Global employee who knew about the transfer of $175 of customer funds towards MF Global's broker dealer operations (I am speculating that this was likely done to meet margin requirements on European debt bets that the firm thought would bounce back in time before anyone was the wiser) that Corzine knew all about the transfers. If Corzine knew about the transfer of $175 million, his testimony to the House Committee of December 8, 2011 wherein he stated that he knew nothing about it was untruthful. Corzine may well have already perjured himself.

Remember that on October 26, 2011, the CME had performed a spot audit on MF Global. On October 24, 2011, the CME initiated a heightened scrutiny of the segregated customer fund reporting of MF Global as a result of MF Global's market risk. Beginning on October 24, 2011, the CME's daily audits verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be.

On October 26, 2011, the CFTC also went into MF Global to make sure that what MF Global reported to be holding in customer segregated funds matched bank balances. The CFTC's spot audit showed that no money was missing.

On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global's stock collapsed and it its bonds began to trade at distressed levels. Corzine utilized all MF Global's credit lines and tried to secure a sale of the firm to Interactive Brokers. On October 26 or October 27, 2011 MF Global provided reports to the CME and CFTC that it had a $200 million surplus in customer accounts. In reality on October 27, 2011, it was covering up a $200 million deficit in customer funds.

Five days later on October 31, 2011, MF Global filed for bankruptcy. But MF Global had already lied to both the CME and CFTC and violated CFTC rules and committed fraud and embezzlement.

On the morning of November 2, 2011, the CME announced that MF Global may have transferred money " in a manner that may have been designed to avoid detection insofar as MF Global did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011." [2]

The first hint of missing customer funds came out in press report on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts. [3]

There are in excess of $158 billion in customer-segregated funds in the United States. The futures markets unlike the securities markets have existed without any meaningful problem or shortfall in domestic customer segregated funds and without needing the existence of any protection like SIPC until October 31, 2011. It is inarguable that the futures markets have been the most crisis-free well functioning markets in the world and remain so. It is unfortunate that because of Jon Corzine these markets may now be portrayed as somehow unsafe for the investment of public funds.

The answer to Corzine is not more regulation but as I have written before, a simple amendment of CFTC Rule 1.25 to prohibit the investment of customer segregated funds in foreign sovereign debt-this amendment has already occurred. It was Corzine himself who lobbied for the change in Rule 1.25 to allow for customer-segregated funds to be held in foreign debt instruments.

Regulation can never rule out the rogue actor or sociopath and must not try because there really are not that many around-Corzine being a case in point. What is least needed is a reactionary and wholesale change in the regulation of the futures markets.@

MF Global's Missing Customer Funds and Its Implications on the Futures Industry

By R. Tamara de Silva

November 28, 2011

Abstract: The collapse of MF Global is an unfortunate and watershed event for the futures industry. The regulated futures markets, long a stepchild of the larger financial markets, have been the most liquid, transparent and crisis free markets in the world. They have been remarkably free from any systemic financial crisis. . .with the exception of a certain salad oil scandal (almost 50 years ago) and until now with MF Global. With former Goldman Sach's CEO Jon Corzine's takeover and bankruptcy of what had been one of the largest and oldest commodity trading firms in the world, the crisis-free reputation of the futures industry is sullied. At the crux of MF Global's fall is CFTC Rule 1.25 which requires that, futures commission merchants ("FCMs"), like MF Global, are allowed to invest and collect interest on customer funds, in excess of customer funds, used as margin for customer trades. Rule 1.25 was amended in 2004 to allow FCMs to invest in sovereign debt (among five other investment vehicles) so long as these vehicles maintained the highest credit ratings by the three credit ratings agencies. If MF Global went into customer segregated funds, which are supposed to separated away from the firm's assets, to meet the FCM's own margin calls, then Corzine and as yet unknown agents will face criminal charges. If however, customer funds were invested in foreign sovereign debt, as firms are allowed to do under CFTC Rule 1.25 and these investments lost over $1.2 billion in value, then there is no criminal liability, only perhaps civil liability. The accounting firm PricewaterhouseCoopers, may face civil liability. A cursory look at all other similar crises from Refco and Griffin Trading (in the futures industry) to Lehman Brothers and rogue trading at UBS, demonstrates that MF Global is unique-this may be the first time in history that customer segregated funds were not properly segregated by an FCM. In any event, $1.2 billion in customer funds would not have been lost had CFTC Rule 1.25 not have been amended in 2004.[1] MF Global's demise has broader implications, other than legal culpability for accounting firms, the effectiveness of self-regulatory organizations and prospective regulation of the futures industry. Lastly, in order to ensure that the futures markets do not have another MF Global, CFTC Rule 1.25 must be amended back to reverse its amendment in 2000 and 2005.

Background

James Man started a sugar trading business in 1783, that became Man Financial and ultimately, the publicly traded MF Global, some 230 years later. In March 2010, a former Goldman Sachs CEO, Jon Corzine became CEO of MF Global joking with not some insignificant degree of obviously unjustified hubris that "I hadn't heard of this company a week ago." Would that he had remained in ignorance.

It was Corzine's stated goal to transform MF Global from a commodity broker into an investment bank with a large proprietary trading operation similar to the one Corzine ran at Goldman in the 1990s. The luster of Corzine's Goldman pedigree was not lost on the Financial Industry Regulatory Authority (FINRA) as they granted Corzine a waiver, from having to have a license to run MF Global. By way of some background, every person in the futures industry has a license, especially everyone interacting with clients.

On October 26, 2011, the Chicago Mercantile Exchange ("CME") performed a spot audit on MF Global. This audit merely verified that customer funds were on deposit at the bank(s) where MF Global represented that they were and in the amount that they were supposed to be. The CME had performed a full audit in January 2011. On October 25, 2011 MF Global reported a substantial quarterly loss due to having leverage of 40:1 on its exposure to European sovereign debt. Predictably, MF Global's stock collapsed and it its bonds began to trade at distressed levels.[2] Corzine utilized all MF Global's credit lines and tried to secure a sale of the firm to Interactive Brokers. Five days later on October 31, 2011, MF Global filed for bankruptcy. There is yet no reason to think that any customer funds, which are supposed to be safeguarded from a futures brokerage going bankrupt by virtue of their being completely segregated, would be in jeopardy.

However, on November 2, 2011, the CME announced that MF Global may have transferred money " in a manner that may have been designed to avoid detection insofar as MF Global did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011." [3]

The first hint of missing customer funds was released on October 31, 2011 when Interactive Brokers announced they are walking away from a purchase of MF Global due to accounting discrepancies. At first MF Global denied anything of the sort, only to admit on November 1, 2011 that there were shortfalls in customer accounts.[4]

Almost one month later, no one can account for where the money has gone. The CME verified that customer money was accounted for on October 26, 2011. It looks as if the money was moved out of customer segregated accounts in the amount of what is now considered to be well over a $1.2 billion shortfall, or the money was lost in trading losses and positions in...you guessed it, sovereign debt. It is possible that legally segregated customer funds could have been lost, in a titanic liquidity squeeze. If this is the case, then no violation of the law that requires customer funds to be segregated occurred.

The illegal scenario is if customer segregated funds were commingled with MF Global's funds. If MF Global went into what are supposed to legally segregated customer funds, that must be completely separated and never used by MF Global either for its own purposes or that of other customers, then fraud and embezzlement would have occurred. Almost one month afterwards, no one outside of MF Global knows which scenario occurred.

Applicable Rules

The key difference between FCMs and securities brokerages is that FCMs, unlike securities brokers, are required by law to keep their customer funds segregated from the FCM's own funds. It is in this way that FCMs have been able, with comparatively few exceptions, to ensure that customer deposits are completely protected from all losses an FCM may incur due to its own proprietary trading. Before MF Global, the requirement that FCMs segregate customer funds completely from their own funds largely prevented FCM customers from losing money due to an FCM bankruptcy.[5]

Having customer segregated funds completely separated and safe from an FCM's own funds and operations meant that protections like SIPC were not needed in the futures world as they are in securities. SIPC on the other hand restores funds to customers with assets in securities brokerage firms.[6] The National Futures Association (NFA) and the CFTC require FCMs to report the amount they carry in customer segregated funds to the clearing house of the FCM's designated self-regulatory organization (DSRO)-in MF Global's case, the CME.

CFTC Rule 1.20 holds that customer funds are to be segregated and separately accounted for.

(a) All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers. Such customer funds when deposited with any bank, trust company, clearing organization or another futures commission merchant shall be deposited under an account name which clearly identifies them as such and shows that they are segregated as required by the Act and this part. Each registrant shall obtain and retain in its files for the period provided in §1.31 a written acknowledgment from such bank, trust company, clearing organization, or futures commission merchant, that it was informed that the customer funds deposited therein are those of commodity or option customers and are being held in accordance with the provisions of the Act and this part: Provided, however, that an acknowledgment need not be obtained from a clearing organization that has adopted and submitted to the Commission rules that provide for the segregation as customer funds, in accordance with all relevant provisions of the Act and the rules and orders promulgated thereunder, of all funds held on behalf of customers. Under no circumstances shall any portion of customer funds be obligated to a clearing organization, any member of a contract market, a futures commission merchant, or any depository except to purchase, margin, guarantee, secure, transfer, adjust or settle trades, contracts or commodity option transactions of commodity or option customers. No person, including any clearing organization or any depository, that has received customer funds for deposit in a segregated account, as provided in this section, may hold, dispose of, or use any such funds as belonging to any person other than the option or commodity customers of the futures commission merchant which deposited such funds.
(b) All customer funds received by a clearing organization from a member of the clearing organization to purchase, margin, guarantee, secure or settle the trades, contracts or commodity options of the clearing member's commodity or option customers and all money accruing to such commodity or option customers as the result of trades, contracts or commodity options so carried shall be separately accounted for and segregated as belonging to such commodity or option customers, and a clearing organization shall not hold, use or dispose of such customer funds except as belonging to such commodity or option customers. Such customer funds when deposited in a bank or trust company shall be deposited under an account name which clearly shows that they are the customer funds of the commodity or option customers of clearing members, segregated as required by the Act and these regulations. The clearing organization shall obtain and retain in its files for the period provided by §1.31 an acknowledgment from such bank or trust company that it was informed that the customer funds deposited therein are those of commodity or option customers of its clearing members and are being held in accordance with the provisions of the Act and these regulations.
(c) Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person, or be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held: Provided, however, That customer funds treated as belonging to the commodity or option customers of a futures commission merchant may for convenience be commingled and deposited in the same account or accounts with any bank or trust company, with another person registered as a futures commission merchant, or with a clearing organization, and that such share thereof as in the normal course of business is necessary to purchase, margin, guarantee, secure, transfer, adjust, or settle the trades, contracts or commodity options of such commodity or option customers or resulting market positions, with the clearing organization or with any other person registered as a futures commission merchant, may be withdrawn and applied to such purposes, including the payment of premiums to option grantors, commissions, brokerage, interest, taxes, storage and other fees and charges, lawfully accruing in connection with such trades, contracts or commodity options: Provided, further, That customer funds may be invested in instruments described in §1.25. [7]

Section 4d(a)(2) of the Commodity Exchange Act also states that customer funds must not be commingled with funds of the FCM nor ever be used by an FCM for any purpose such as margining other customer accounts or that of the FCM itself.

Section 4d(a)(2) of the CEA and related Commission regulations require that, among other things, all funds deposited with an FCM to purchase, margin, guarantee, or secure futures or commodity options transactions and all accruals thereon, be accounted for separately by the FCM and deposited under an account name that clearly identifies
them as such, not be commingled with the FCM's own funds, and be held for the benefit of customers.\4\ The segregation requirements are intended to prevent an FCM from using customer property to margin the trades of other customers or of the FCM itself. Further, the Division has interpreted the segregation requirements to preclude any
impediments or restrictions on the FCM's ability to obtain the immediate access to customer funds. The immediate and unfettered access requirement avoids potential delay or interruption in securing required margin payments that, in times of significant market disruption or otherwise, could magnify the impact of such market disruption and impair the liquidity of other FCMs and clearinghouses. [8]

The stage was set for MF Global on February 3, 2005, when the CFTC published proposed amendments to its Rule 1.25, which governed what types of investments an FCM may make of customer segregated funds. Before 2000, FCMs and designated clearing organizations ("DCOs") were only permitted to invest in United States debt (including municipal and state debt).

CFTC Rule 1.23 allows FCMs and DCOs to collect interest in the customer-segregated funds they hold.[9]

The provision in section 4d(a)(2) of the Act and the provision in §1.20(c), which prohibit the commingling of customer funds with the funds of a futures commission merchant, shall not be construed to prevent a futures commission merchant from having a residual financial interest in the customer funds, segregated as required by the Act and the rules in this part and set apart for the benefit of commodity or option customers; nor shall such provisions be construed to prevent a futures commission merchant from adding to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in §1.25, as it may deem necessary to ensure any and all commodity or option customers' accounts from becoming undersegregated at any time. The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. A futures commission merchant may draw upon such segregated funds to its own order, to the extent of its actual interest therein, including the withdrawal of securities held in segregated safekeeping accounts held by a bank, trust company, contract market clearing organization or other futures commission merchant. Such withdrawal shall not result in the funds of one commodity and/or option customer being used to purchase, margin or carry the trades, contracts or commodity options, or extend the credit of any other commodity customer, option customer or other person. [10]

On May 17, 2005, the CFTC published final rules that further amended Rule 1.25 to allow for the practice of FCMs using repurchase agreements called "repos" with customer funds. A repo is simple the sale of a security (typically a government debt) tied to an agreement to buy the securities back later. A reverse-repo is the purchase of a security tied to an agreement to sell back later. Repos are essentially loans secured against a security. The interest rate received is called the repo rate. The party that sells a security agreeing to buy it back in the future at a higher price later is engaging in a repurchase agreement. The party that agrees to buy the security and sell it back in the future is engaging in a reverse repo.

The use of repos by MF Global would have permitted the firm to leverage customer deposits, although it is unknown that they did. However, leverage of 30:1 or greater, through the use of repos would have resulted in larger losses if the repos were in sovereign European debt.

CFTC Rule 1.25 governs the investment of customer funds by an FCM.

(a) Permitted investments. (1) Subject to the terms and conditions set forth in this section, a futures commission merchant or a derivatives clearing organization may invest customer money in the following instruments (permitted investments):
(i) Obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities);
(ii) General obligations of any State or of any political subdivision thereof (municipal securities);
(iii) General obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities);
(iv) Certificates of deposit issued by a bank (certificates of deposit) as defined in section 3(a)(6) of the Securities Exchange Act of 1934, or a domestic branch of a foreign bank that carries deposits insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes or bonds;
(vii) General obligations of a sovereign nation [emphasis added]; and
(viii) Interests in money market mutual funds. [11]

CFTC Rule 1.32 specifies how FCMs are required to compute the value of customer segregated accounts on a daily basis.

(a) Each futures commission merchant must compute as of the close of each business day, on a currency-by-currency basis:
(1) The total amount of customer funds on deposit in segregated accounts on behalf of commodity and option customers;
(2) the amount of such customer funds required by the Act and these regulations to be on deposit in segregated accounts on behalf of such commodity and option customers; and
(3) the amount of the futures commission merchant's residual interest in such customer funds.
(b) In computing the amount of funds required to be in segregated accounts, a futures commission merchant may offset any net deficit in a particular customer's account against the current market value of readily marketable securities, less applicable percentage deductions ( i.e., "securities haircuts") as set forth in Rule 15c3-1(c)(2)(vi) of the Securities and Exchange Commission (17 CFR 241.15c3-1(c)(2)(vi)), held for the same customer's account. The futures commission merchant must maintain a security interest in the securities, including a written authorization to liquidate the securities at the futures commission merchant's discretion, and must segregate the securities in a safekeeping account with a bank, trust company, clearing organization of a contract market, or another futures commission merchant. For purposes of this section, a security will be considered readily marketable if it is traded on a "ready market" as defined in Rule 15c3-1(c)(11)(i) of the Securities and Exchange Commission (17 CFR 240.15c3-1(c)(11)(i)).
(c) The daily computations required by this section must be completed by the futures commission merchant prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31. [12]

CFTC Rule 30.7 covers the treatment of foreign futures or foreign options and the investment of customer funds in foreign instruments.

(a) Except as provided in this section, a futures commission merchant must maintain in a separate account or accounts money, securities and property in an amount at least sufficient to cover or satisfy all of its current obligations to foreign futures or foreign options customers denominated as the foreign futures or foreign options secured amount. Such money, securities and property may not be commingled with the money, securities or property of such futures commission merchant, with any proprietary account of such futures commission merchant, or used to secure or guarantee the obligations of, or extend credit to, such futures commission merchant or any proprietary account of such futures commission merchant.
(b) A futures commission merchant may deposit together with the secured amount required to be on deposit in the separate account or accounts referred to in paragraph (a) of this section money, securities or property held for or on behalf of other customers of the futures commission merchant for the purpose of entering into foreign futures or foreign options transactions. In such a case, the amount that must be deposited in such separate account or accounts must be no less than the greater of (1) the foreign futures and foreign options secured amount plus the amount that would be required to be on deposit if all such customers were foreign futures or foreign options customers under this part 30, or (2) the foreign futures or foreign options secured amount plus the amount required to be held in a separate account or accounts for or on behalf of customers pursuant to any law, or rule, regulation or order thereunder, or any rule of any self-regulatory organization authorized thereunder, in the jurisdiction in which the depository or the customer, as appropriate, is located.
(c) (1) The separate account or accounts referred to in paragraph (a) of this section must be maintained under an account name that clearly identifies them as such, with any of the following depositories:
(i) A bank or trust company located in the United States;
(ii) A bank or trust company located outside the United States:
(A) That has in excess of $1 billion of regulatory capital; or
(B) Whose commercial paper or long-term debt instrument or, if a part of a holding company system, its holding company's commercial paper or long-term debt instrument, is rated in one of the two highest rating categories by at least one nationally recognized statistical rating organization; or
(C) As designated;
(iii) A futures commission merchant registered as such with the Commission;
(iv) A derivatives clearing organization;
(v) A member of any foreign board of trade; or
(vi) Such member or clearing organization's designated depositories.
(2) Each futures commission merchant must obtain and retain in its files for the period provided in §1.31 of this chapter an acknowledgment from such depository that it was informed that such money, securities or property are held for or on behalf of foreign futures and foreign options customers and are being held in accordance with the provisions of these regulations.
(d) In no event may money, securities or property representing the foreign futures or foreign options secured amount be held or commingled and deposited with customer funds in the same account or accounts required to be separately accounted for and segregated pursuant to section 4d of the Act and the regulations thereunder.
(e) Each futures commission merchant which invests money, securities or property on behalf of foreign futures or foreign options customers shall keep a record showing the following:
(1) The date on which such investments were made;
(2) The name of the person through whom such investments were made;
(3) The amount of money so invested;
(4) A description of the obligations in which such investments were made;
(5) The identity of the depositories or other places where such obligations are maintained;
(6) The date on which such investments were liquidated or otherwise disposed of and the amount of money received of such disposition, if any; and
(7) The name of the person to or through whom such investments were disposed of.
(f) Each futures commission merchant must compute as of the close of each business day:
(1) The total amount of money, securities and property on deposit in separate account(s) in accordance with this section;
(2) The total amount of money, securities and property required to be on deposit in separate account(s) in accordance with this section; and
(3) The amount of the futures commission merchant's residual interest in money, securities and property on deposit in separate account(s) in accordance with this section. Such computations must be completed prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of §1.31.[13]

Rule 1.25 was amended in 2005 in part because of lobbying by the FCMs, including ironically support from MF Global's current General Counsel.

The principal changes to Rule 1.25 that would have likely affected, or one should say enabled the fall of MF Global involved reverse repos, transactions within FCM that are also broker-dealers ("BDs") and possibly the elimination that investment in money market funds carry the highest credit rating.

Before 2005, CFTC Rule 1.25(b)(4)(iii) imposed concentration limits as to both the issuer and the counterparty in reverse repos, which limits are different from the concentration limits on direct investments. After 2005, the concentration limits would apply to all investments in securities, whether obtained pursuant to direct investment or pursuant to reverse repos.

After 2005, FCMs that are also broker-dealers were allowed to engage in-house transactions involving the simultaneous exchange of customer cash or customer-deposited securities for securities held by the FCM also in its capacity as a broker dealer. What this means is that an FCM can seemingly do both a repo and reverse repo at once-taking both sides. FCMs acting also as BDs would enable the exchanging of securities for a customer so that what is not acceptable as margin at a specific clearing firm would be exchanged by the FCM for another security that would be acceptable.

Another revision of CFTC Rule 1.25(b)(2)(i)(E) eliminated the requirement that FCMs and DCOs that invested customer funds in Money Market Mutual Funds ("MMMFs") invest only in MMMFs that carried the highest ratings by the credit ratings agencies.

Criminal or Civil Liability Contingent on Fraud

The criminal or civil liability, if any, of Corzine and his agents at MF Global, will likely rest on whether customer funds were properly segregated and not commingled with FCM funds, or whether they were converted for use of MF Global. The later situation would involve not just fraud, but also embezzlement-it would constitute a criminal violation of CFTC and SEC rules, et. al. The difference between civil liability and criminal wrong-doing is illustrated by looking at the tale of three FCMs, Refco, Griffin Trading Company and Lee B. Stern & Co.

Refco was once the largest futures brokerage at the CME but will be remembered as possibly the shortest IPO in history. Refco raised and lost over $1billion in investor capital before it went public in August 2005 and bankrupt in October of 2005.

Refco was co-founded by Tom Dittmer and Ray Friedman in 1969. Amid some regulatory scuffles, Dittmer resigned and was replaced by a new CEO, Phillip Bennett.
An internal audit of Refco revealed that Bennett had taken $430 million from Refco's and manipulated Refco's financials to disguise his taking. Refco's accounting firm, Grant Thornton after a complete audit, and all the investment banks that handled the IPO, including Goldman Sachs, and Bank of America Corp., after their due diligence, missed the $430 shortfall. Federal authorities were alerted of the missing funds by Refco's own internal audit. Bennett repaid all of the money but the public had lost faith in the company. Investors sold billions of shares worth of Refco and the resulting liquidity run forced the firm into bankruptcy.

The Justice Department filed criminal charges against Refco principals Phillip R. Bennett, Tone N. Grant, Santo C. Maggio and Robert C. Trosten for fraudulently hiding trading losses of both Refco's and of its customers, and fraudulently manipulating financial statements to secure a leverage buyout of the firm and subsequent IPO.[15] In addition to obtaining guilty pleas and convictions against all of them, the government recovered obtained over $33,000,000 in forfeiture actions against five other Refco officers, including Tom Dittmer. There were also civil suits and a class action.

By contrast, no criminal charges were filed against any of the principles of Griffin Trading Company, a futures commission merchant, that collapsed overnight on December 23, 1998 as a result of the trading losses of one of their customers in London, John Ho Park, lost nearly $10.3 million on December 21 and 22, 1998. Griffin Trading Company was founded by Farrel J. "Tex" Griffin, a former assistant U.S. attorney, and Roger S. Griffin (the two are not related). Some customer funds in segregated accounts were lost in London, but there was no question of criminal liability because customer funds in the United States were segregated and never commingled. Unlike in Refco's case, no one at Griffin committed any fraud.

In the case of Griffin Trading, all customers with money held in the United States did not suffer because their funds were held in segregated customer accounts. Customers of Griffin that had funds in London lost their money because at the time the Securities and Futures Authority's Client Money Rules ("SFA Rules") did not prohibit the use of one customer's money to cover another customer's losses. Although SFA Client Money Rule 4-55 did require that customer accounts be segregated from the firm's account, there was no prohibition on their being commingled with other customer accounts in one pool. This arrangement is typically called having one omnibus account (segregated but pooled account) as opposed to separate sub-accounts for each customer, as required by law in the United States. As a result, customers sued Griffin Trading in bankruptcy proceedings for money lost in the U.K.[16]

On October 22, 1992, two rogue bond traders at the Chicago Board of Trade ("CBOT") made unauthorized trades (they exceeded their trading limits) and forced the clearing firm Lee B. Stern & Co. to default on a $8.5 margin call to the CBOT's Clearing Corporation. The two rogue traders caused a loss to the FCM that exceeded its net worth by $2 million. Lee Stern made up for the shortfall personally, saved the firm and ensured that no customers lost any money-although his firm did lose its clearing status and was never again a member of the Chicago Board of Trade Clearing Corporation.

In the history of financial futures and FCM, customers have seldom if ever lost money even because of rogue trading by FCM employees or other customers because the FCMs, historically at the immediate behest of the exchange clearing house, have made sure that customers were made whole.

Were this not the historic practice within the futures industry and in theory an FCM's entire customer segregated account pool (segregated and not commingled as it may be) would be jeopardized and placed at risk by the trading of one customer making trades they cannot cover and are too large for the capital reserves of the FCM to cover. To put this in perspective, the futures industry has, other than for the very few examples above, had good risk practices.

What happens with MF Global depends on what happened to the missing money and whether it was segregated also not commingled after the CME's spot audit of October 26, 2011.

Liability of PricewaterhouseCoopers

Some ironies are worse than others. The CFTC has subpoenaed Pricewaterhouse Coopers ("PwC") presumably for any information is may have about Mf Global's missing customer funds. PwC advertises what lessons auditors should have learned from the collapse of Lehman Brothers on their website.[17] PwC gave MF Global an unqualified (clean) audit opinion on May 20, 2011. MF Global's bankruptcy is now considered to be the eighth largest in United States history.

One cannot help but wonder at times what use are auditing firms in terms of catching or preventing large financial crisis...ever? Grant Thornton issued an unqualified audit of Refco before its IPO. Lehman, AIG and a host of other financial titans received unqualified audit opinions preceding their failures and bankruptcies.

Are accounting firms like credit ratings agencies in that it is not in their interest to issue qualified opinions because they would in so doing drive themselves out of business? Or are they like the credit ratings agencies (MF Global was downgraded to junk after it filed for bankruptcy-so the ratings agencies were all over this after the fact), and incapable of understanding the securities and market risks of the firms they are paid to pass judgment over?

In their defense, PwC might have been dealing with a rogue trading situation-perhaps Corzine himself, some late stage commingling and embezzlement of customer funds or perhaps just over-leveraged positions in European sovereign debt that coincidentally took a dramatic turn for the worse (they did in fact) during the last weeks of October.

Future Regulation Must Rescind Changes to Rule 1.25

The risk free rate of return is the yield on 30 day United States T-bills. Had MF Global been prohibited from investing customer funds in sovereign European debt or using internal repos (assuming they have done either or both), then their customers' money would be inarguably safer at all times. Customer segregated funds held in T-bills or other United States debt instruments are safer than they would be invested in anything else. The CFTC must amend all the changes to Rule 1.25 that went into affect on 2004 and 2005, including the permission to invest in foreign sovereign debt that became law in 2000.

Regulating What Cannot Be So

The CME is MF Global's "primary regulator." Many argue that it is the exchange's role to have better policed MF Global. However, to impose this burden on the CME is not necessary because it is the CFTC that proposed and finalized all the rules to allow for an FCM's investment of customer funds by the use of repos and in a foreign sovereign debt.

No one has a greater interest in avoiding events like Corzine's MF Global than the CME. To be fair, the exchanges have historically maintained a stellar track record as self-regulatory organizations that police their member firms, whether clearing members or non-clearing member firms. The case of MF Global is of monumental significance to the entire futures industry because it may tragically portray the investment of public funds in the futures markets as somehow unsafe and unprotected.

Regulation can never rule out the rogue actor or sociopath. Whatever costs Corzine was determined to incur upon the world in his quest to self-glorification by making a 230 year firm, a proprietary trading desk, the world must take solace in one simple fact-there are not that many Corzines.

A wholesale revision of the futures regulatory regime would be unfortunate and ineffective because no regulatory regime or social science model can account for the irrational or mad actor-nor must it ever try.@
R. Tamara de Silva
Chicago, Illinois

R. Tamara de Silva is a securities lawyer and independent trader

Any questions about this article should be directed to tamara@desilvalawoffices.comFootnotes:
1. Unless Corzine or his agents deliberately stole this money out of customer accounts, which no one not even the CME has either confirmed or denied.
2. The fact that European sovereign debt was reaching crisis levels began to be apparent to most of the world in 2009 and MF Global's 40:1 leverage and exposure to it should have signaled a red alert to its auditor PwC...but strangely did not seem in any way troublesome to PwC-certainly not worthy of actually pointing out or giving a qualified opinion!
3. http://cmegroup.mediaroom.com/index.php?s=43&item=3202&pagetemplate=article
4. http://online.wsj.com/article/SB10001424052970204394804577012061970129588.html?mod=googlenews_wsj

5. Please see discussion of Griffin Trading Company and Refco cases
6. It is important to remember that SIPC protection does not apply in cases involving fraud or rogue trading like with Barring Bank's Nick Leesen. Were SIPC in play with MF Global, it would not cover losses causes by any fraud or malfeasance on the part of MF Global-were any found to have occurred.
7. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=de913862c8633d27e5dbb751f541f29e&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.15&idno=17
8. http://www.cftc.gov/foia/fedreg05/foi050202a.htm
9. It is important to keep in mind that the yield received by the FCMs and DCOs investment of customer segregated funds has historically been a large profit center for them.
10. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=1e218e6499b67aee6c250eae86e59bf9&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.18&idno=17
11. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=de913862c8633d27e5dbb751f541f29e&rgn=div8&view=text&node=17:1.0.1.1.1.0.4.20&idno=17
12. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=1a1599ee01c68b489e7394311a832812&rgn=div8&view=text&node=17:1.0.1.1.1.0.5.27&idno=17
13. http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=541c9995ee3b4f389cf3273d6aec19f4&rgn=div8&view=text&node=17:1.0.1.1.21.0.7.7&idno=17
14. http://mobile.bloomberg.com/news/2011-11-16/tiny-rule-change-was-at-the-heart-of-mf-global-s-failure-william-d-cohan
15. United States v. Bennett, 485 F.Supp.2d 508 (2007)
16. In re Griffin Trading Co., 245 BR 291 (2000)
17. http://www.pwc.com/jg/en/events/Lessons-learned-for-the-survivors.pdf